Option Investor

Daily Newsletter, Wednesday, 7/14/2010

Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews

Market Wrap

Weak Follow Through to INTC's Earnings

by Keene Little

Click here to email Keene Little
Market Stats

James and I have switched nights again this week. He'll be with you tomorrow night.

There was a big effort to hold the market up this morning as the major indexes got a lift while some of the other sectors, like banks, were not supportive. It's always hard to tell during opex week what's going to be the true direction of the market. After Intel (INTC) reported earnings yesterday afternoon, which not surprisingly was a good earnings report, futures shot higher in after-hours trading. It's a very typical story that plays out repeatedly. The 2nd half of the story is that the following day then sells off. By the start of trading today the gain in the futures had washed away and the market opened basically flat and then the effort to hold the market up began. While the indexes got a little push in the final 15 minutes of trading to get them to the flat line or slightly positive, you can see the down volume and declining issues nudged out up volume and advancing issues.

What's interesting about the companies announcing earnings so far, and who were given credit for the market's rally, is that their stock prices have not fared all that well following their earnings report. Alcoa (AA) shot higher after hours on Monday and gapped up Tuesday morning, but it quickly closed its gap early Tuesday morning and finished marginally higher on Tuesday. It left a big red candle on Tuesday with its open and high at its 50-dma and then sold off some more today. CSX Corp (CSX) had good earnings and gapped up after hours on Monday but Tuesday it closed below Monday's regular closing price. Its daily candle on Tuesday was a bearish engulfing pattern (reversal) and then gapped down today. It climbed back into positive territory but then settled only marginally positive for the day.

Following INTC's big pop higher in after-hours trading Tuesday evening, it gapped higher this morning, quickly made a high of 22.25 and then sold off the rest of the day, closing in the green but down at 21.36 (+0.35) and left an ugly red candle today. From a pattern perspective and Fib targets reached, it looks like INTC finished its correction to the decline from April. Just another sell-the-news event. If this is the way this earnings season is going to go we don't have much to look forward to as far as additional upside to the market.

Ever since the low in May we've heard a lot of people talking about the potential for a big H&S topping pattern (the left shoulder was in January, the head in April and then the need for a right shoulder). The right shoulder was formed by the bounce into June. The neckline, near SPX 1040, was then broken with the decline into the end of June, down to 1010.91. The bears were rejoicing about the break of the neckline. I was worried the H&S pattern was being discussed by too many and that the pattern would fail, just like it did in July 2009 with the head-fake break of the neckline followed by a slingshot higher into August.

Now it's looking like a repeat of the 2009 H&S pattern and failure. And now we've got almost everyone talking about a new rally having been born, just like the one off the July 2009 low. Even the strong rally following the July 1st low has been compared to the rally off the July 2009 low. But once again I'm wondering if too many are now expecting a large rally based on last year's pattern. As the saying goes, if it's obvious to many it's obviously wrong.

The stock market has moved quickly from oversold at the July 1st low to overbought today. But many are thinking that the market will head much higher because there's too much bearish sentiment. The put/call ratio has actually been neutral and the Daily Sentiment Index (DSI from trade-futures.com) tracks daily changes in trader sentiment and as shown in the chart below, as of last Friday, the DSI was back up to 35% bulls, near the levels seen at previous rally highs. I suspect the DSI is much higher after this week's rally. CNBC is taking polls to see how many believe the DOW will hit 11K before Labor Day. My vote? Uh, no.

S&P 500 and Daily Sentiment Index, chart courtesy elliotwave.com

Many financial advisors are recommending their clients stay fully invested in the market and not let little "dips" scare them out. After the market sold off into the end of May, near SPX 1068, the Intelligence Advisors Sentiment survey (InvestorsIntelligence.com) showed about 39% stock market advisors were bullish. The market bounced and then sold off to a lower low by the end of June and the survey showed an increase in stock market bulls to about 41%. Advisors continue to counsel their clients to stay the course and not let the market scare them out of their positions. The strong bounces off the lows keep people complacent and invested but the increase in bullishness sets the market up for potential disappointment.

Another interesting thing that's happening in the market, something that adds to the risk of being long anything, is the close correlation between markets. The chart below shows the correlation between the S&P 500 and six other markets, using the market that is the least correlated at the time, calculated on a rolling 3-month basis. In case it's hard to read, the chart starts in 2007 and the rising peaks show increased correlation which correspond to stock market peaks (followed by either consolidation or steep drops). The current peak, at the end of June, was nearly 80% and warns of another stock market peak.

Correlation of markets with the S&P 500, chart courtesy Bianco Research

Again, if it's hard to read, the six markets are gold, 10-year yield, investment grade spreads, the Euro, 10-year TIPS Breakevens, and crude oil. With the current 80% correlation it tells us all these markets are trading essentially in synch with the stock market. It's part of the "all-the-same" market theme where the buying and selling happens across the board and many attribute it to the plethora of ETFs and to program trading. The risk for the market is that when one sector gets hit it's likely going to mean all of them are going to get hit. It becomes a market where there's nowhere to hide. We're seeing increased volatility in the markets with some very large price swings and the tighter correlation makes the market more vulnerable to these swings.

What's particularly disturbing for our current market is the fact that the stocks are more closely correlated today than at any time since just before the 1987 stock market crash. Birinyi Associates discussed this recently in the Wall Street Journal and the chart below shows the history since the 1980s. There was a spike up to just above 80% correlation just before October 1987. The most recent high before today was in October 2007 and now the correlation has increased above the 2007 high and approaching the 1987 high.

Stocks correlated to the S&P 500, chart courtesy Birinyi Associates

The reason this is scary is because when selling, or buying, starts we then get a big move in all stocks. This helps explain all the 90% up and down days we've been getting this year. The flash crash in May was probably just a warning shot across the bow that might only be recognized in hindsight. At least that's the risk with the way the market is heading. We've got a situation where all markets are synching up like very few times in history and when they get this synched up it hasn't been good for any of the markets (panic tends to show up more often in selling rather than buying).

So the market has been acting a bit bipolar lately and the latest bounce, off the July 1st low, has been one of the strongest in both points and time since last year. But this market has a habit of turning on a dime and leaving traders unable to change as quickly. Trade carefully, no matter which direction you're trading.

Starting off with the SPX weekly chart, price has stalled at the 50-week moving average, near 1096, a moving average that has done a very good job over the years at showing us when we are in a cyclical bull or bear market. It had minor breaks during the 2003-2007 rally but always recovered by the end of the 2nd week. When it finally broke in December 2007 it then acted as resistance in May 2008 and wasn't broken to the upside until July 2009. Currently this is the 4th week that SPX has been below its 50-week and any failure to close above it this week would likely mean it's going to continue to act as resistance in the new bear market cycle.

S&P 500, SPX, Weekly chart

SPX is trying to poke above the downtrend line from April, currently near 1095, but for the past two days has not been able to hold above it. Assuming we're going to get another leg down to a new low below the July 1st low, I'm using a parallel down-channel for guidance. There are a couple of ways to count the move down from April and one, which is a corrective count (shown on the RUT's chart later), says a decline will stay within the down-channel. The impulsive wave count, which is shown on the SPX charts, suggests price will drop out the bottom of the channel (in a 3rd of a 3rd wave down). Obviously we won't know the answer to that question until it drops down and we get to see how it looks down there. But in either case, the current wave count calls for at least another leg down rather than a continuation of the rally from here. Today's doji stars for the indexes at resistance could be a reversal signal in the making if Thursday is a down day.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish above 1105
- bearish below 1058

If the market does not start back down from here we could see a continuation of the current rally up to a price projection near 1157, shown on the above chart with a dashed line. This would be for a larger bounce pattern off the May 25th low (and would support the corrective wave count that I'll show later on the RUT's chart). The Fib projection for the c-wave of a larger a-b-c bounce off the May 25th low is where it would be 162% of the a-wave. A rally above 1105 would suggest this short-term bullish pattern could play out before the market drops back down to new annual lows.

Today SPX fell out of its rising wedge pattern from last week's low. If the rising wedge pattern is correct we should see a quick retracement of it but it's possible we'll see a strong effort to hold the indexes up at least through Friday's opening settlement price. Unless we get new highs almost immediately Thursday morning (dashed line and above 1105) the market is now vulnerable to a selloff from here. Below 1075 would be confirmation we've probably seen the high for the bounce.

S&P 500, SPX, 60-min chart

Like SPX, the DOW is trying to break free of its downtrend line from April, near 10320. It was able to close above it yesterday and today but it's struggling with its 200-dma at 10375, closing below it both days. It's bullish consolidating on top of its broken downtrend line and at its 200-dma so any continuation of the rally this week would be bullish. In that case I think there's a good chance we'll see the rally continue into next week and potentially up to the price projection near 10940. That's the short-term bullish setup here. The bearish wave count calls for selling on Thursday as the market starts back down to new lows.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish above 10,595
- bearish below 10,040

I'm going to look at the Nasdaq Composite this week instead of the Nasdaq-100 because of the tough position it's currently in. It's as if the bullies have surrounded the helpless kid on the playground here. Today the Nasdaq filled its gap left behind on June 24th by hitting 2254 and has run into its 200-dma, 50-dma (which is crossing down through the 200, a bearish signal) and its downtrend line from April, all located in the 2251-2260 area. For this reason, if the Nasdaq is able to push through all this resistance, kung-fu fighting the bullies into submission, it would be a strong bullish statement. For that reason, respect any close above 2260. In the meantime I think I'll place odds on the bullies pulverizing the little kid and expect to see the Nasdaq tuck tail and run. We should see a drop down at least to the bottom of a parallel down-channel, near 1930 by the end of next week. The more bearish pattern calls for a break below the bottom of the channel. As with the other indexes, today's doji star at resistance is either a sign of indecision/consolidation or it's the middle candle of a reversal pattern (evening star, which needs a red day on Thursday to confirm the reversal).

Nasdaq Composite, COMPQ, Daily chart

Key Levels for COMPQ:
- cautiously bullish above 2260
- bearish below 2183

After INTC's strong earnings announcement the semiconductor index bolted out of the gate this morning. It gapped up, like INTC, but then sold off for the rest of the day, closing in the red and near its low for the day. It was not a bullish day and in fact the closing price is a little shy of being able to call the candlestick pattern a dark cloud cover, which is a bearish reversal pattern. Another red candle on Thursday would confirm it. For the wave count on the SOX I've got a slightly different one from SPX and the RUT, sort of a combination of the two. It calls for a stronger decline than the RUT's but perhaps not quite as strong as SPX. It's just another possibility that I'll be watching for.

Semiconductor index, SOX, Daily chart

The RUT has been able to close above its 200-dma the past two days, currently near 638, so that's bullish. Its downtrend line from April and 50-dma are both near 649 and a relatively small push above yesterday's high near 644 could have it tagging the upper resistance line. Anything above 650, especially on a closing basis would be short-term bullish whereas a reversal back down below 617 would confirm the high of the bounce is in place. The wave count for the RUT says we'll see a continuation lower but in a much choppier fashion than what I'm showing on the other charts. The decline would likely stay inside the parallel down-channel that I have on the chart, the bottom of which will be near the price projection near 549 by next week. It takes a break below the bottom of the channel to indicate one of the more bearish wave counts is the correct one. Both call for another leg down but then we'll have to see what it looks like and which count would become the preferred one.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 650
- bearish below 617

The RUT tagged a potentially important price level yesterday when it hit the 644 area. But it's still holding above its uptrend line from July 6th, which so far looks like the bottom of a rising wedge pattern. It's possible we'll see a relatively minor new high near 650 as one more leg up inside the wedge pattern. As long as 650 holds (+/-) we should then see it head south at a relatively high rate of speed. An immediate selloff Thursday morning, especially with a break below 631, would mean the top is already in.

Russell-2000, RUT, 60-min chart

While the blue chips were trying to rally today the banks were a no-show. In fact with the SOX declining and the banks in the red I did not trust any effort to rally the blue chips. It looked like opex manipulation to me. If the banks continue to sell off on Thursday I would not trust any effort to rally the blue chips, especially if the techs and small caps are not participating in any rally attempt. But I do see the possibility for the BKX to rally up to the 52 area before finishing its bounce pattern. It at least closed above its 50-dma today for the second day in a row. A drop back below 48 would have it below its broken downtrend line and its 200-dma so that's the sell signal for the bears to watch for.

KBW Bank index, BKX, Daily chart

The TRAN ran into trouble at its 50-dma in June and today was its first attempt to punch through since mid June. It did not have any success in holding above it so any repeated attempts to get through but closes below it will tell us the same fate may befall the Trannies.

Transportation Index, TRAN, Daily chart

When looking at the nine sectors of the S&P 500 (Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industry, Materials, Technology and Utilities) you can often get a sense of where the market may be headed on a longer-term basis. Financials often lead the way higher off significant bottoms and turn down first from significant highs. But financials have been all over the place and their volatile price action has made them less useful in the past couple of years. A defensive move by the market often shows up in the outperformance of the Consumer Staples, Health Care and Utilities sectors.

If we look at the relative strength (RS) of the utility sector (UTY) vs. the S&P 500 we can see it has outperformed the market since the April high. This outperformance by UTY tells us the market has become very defensive and any continuation of UTY's relative strength should be of concern to bulls who are hoping for a continuation of the bull market. Keep in mind that the RS chart of UTY can keep climbing even if UTY itself is declining but is declining at a slower pace than SPX.

RS of Utility index vs. S&P 500, Daily chart

Looking at the chart of the UTY itself doesn't show any particular strength. The only thing it hasn't done is decline more strongly with the broader averages (hence its relative strength). But UTY has bumped up against its downtrend line from December 2009, and actually it's up against a more significant downtrend line from January 2008. Its daily RSI looks like it could roll over from overbought at any time, and this while price is at resistance. If one of the stronger sectors turns back down here it could be a strong signal that the broader market will do the same.

Utility index, UTY, Daily chart

The first leg of the U.S. dollar's pullback looks like it could be close to finishing if it did not finish today. It has tagged the 38% retracement of the November-June rally and the pattern of the leg down looks complete. As shown on the weekly chart below, a bounce into August before dropping a little lower into the end of September is speculative but would be a typical a-b-c correction of the rally from November. If the dollar starts to rally then the Euro will decline and the stock market should decline as well (remember the 80% correlation chart I showed earlier).

U.S. Dollar contract, DX, Weekly chart

As part of an "all-the-same" market, commodities are likely to decline with the stock market if the dollar begins to rally. The commodity related equity index shows the same setup as the major averages. The current rally has stopped at its downtrend line from April, only slightly above its 50-dma. The daily oscillators look ready to roll back over as price struggles at resistance. The setup looks good for a selloff from here.

Commodity Related Equity index, CRX, Daily chart

No surprise (to me), gold also looks ready to turn lower. The bounce off the July 7th low has been very choppy (corrective) on top of its uptrend line from October 2008. It looks like a consolidation on top of support before support breaks, which I'm expecting it will do. It looks ready to either decline from here or its bounce pattern would look better with one more leg up to about 1225 before letting go. Watch the series of higher lows since July 7th and when the uptrend line along those lows breaks it should be your signal to go short.

Gold continuous contract, GC, Daily chart

The bounce in oil since its low on July 6th has been stronger than gold's but it should be about finished if it didn't finish today. A break below yesterday's low at 74.25 would indicate the bounce has finished and a very sharp decline should be next.

Oil continuous contract, CL, Daily chart

Today's economic reports included retail sales and they came in generally disappointing. While sales were "less bad" than in June (improving from a -1.1% decline to July's -0.5%) they declined more than the expected -0.2%. Much of the blame went to the unemployed (don't they know they're still supposed to be consuming?) and the renewed downturn in the housing market.

Export and import prices dropped, both of which had seen increases in June. This of course is "disinflation" showing up in the numbers again. But fear not, the Fed said in its FOMC minutes, released today, that the numbers they're reviewing requires only a slight downward revision to their growth and inflation expectations for the rest of 2010 and 2011. Only a few Fed governors feel there's at least some risk of deflation.

However, just in case they might be just a wee bit too optimistic about the economy the Fed mentioned they have more tools available to help fight deflation and any further slowing of the economy. They agreed to study what steps "might become appropriate" if the economy stalls and slows down again. None of the 17 policymakers are forecasting a double-dip recession (perhaps because they too realize we never came out of the first one).

Some additional steps the Fed could take would be a resumption of their purchases of mortgage securities in an effort to hold down mortgage rates. The trouble is mortgage rates are already at historical lows and it's still not enticing buyers to bite. And longer-term Treasuries are already quite low. The Fed can also continue to purchase Treasuries (monetizing the government's debt) which would allow the government to implement more stimulus plans (since the first ones have worked so well, cough). In his latest speech, given on Monday (Restoring the Flow of Credit to Small Businesses), Bernanke is imploring banks to ease up on credit standards for viable small businesses. I would imagine it's frustrating watching the credit market starting to freeze up again, as it is in Europe, and not be able to do much about it, except plead.

Bernanke has said in the past that the Fed has ways to ensure Treasury rates stay low (by having the Fed balloon its balance sheet to take on more Treasuries) and can target specific maturities to keep the rates low. This in turn is designed to encourage more borrowing by consumers and businesses so that the economy grows. That sounds great in theory but if people and businesses don't want to borrow then even with rates pushed down to zero it's not going to work this time. If the Fed is fighting a much bigger problem than it has since the Great Depression then there's literally nothing they can do to stop this cycle from running its course. But they'll spend a lot more of our money that we don't have in effort to say they at least tried.

Business inventories dropped a little lower and that will have a negative effect on GDP, as will the worsening trade deficit, which we got yesterday. These are all contributing to the downgrades we're hearing about GDP for the rest of the year. And yet the stock market bravely holds on...

Tomorrow's reports include the PPI numbers and we'll see how much more "disinflation" is creeping in. The market expects a slight improvement or the same for the numbers. The NY Fed Empire Manufacturing index, industrial production and capacity utilization will all add to the picture about how our economy is doing. Any further evidence of a slowdown could start to spook those who have been thinking the past week's rally means the economy is getting better.

Economic reports, summary and Key Trading Levels

Summarizing tonight's charts, the majority of the indexes are either at or very close to some strong resistance levels. There's a big effort to hold the market up into opex (after doing a stellar job rallying it into opex, again) and that could continue at least through Friday morning to get the settlement prices on the big European index options. So perhaps another doji day for Thursday.

It would be potentially bullish if the market is able to push higher, especially above the key levels just above. But it would have to do so on a closing basis so be careful about getting sucked into an intraday move higher that doesn't hold onto the gains. If we see another shift from buying into the close back to selling into the close, it would be another sign of a reversal in the making.

If the market sells off on Thursday, especially below the key levels to the downside (even with just an intraday break), it will be a strong signal that the top of the bounce is in place. Considering the downside potential for a strong decline into next week and the end of the month I think a sell signal here is a good shorting opportunity. Be careful with any new short entries here but now is the time to look for one.

I'll leave you with one last chart for today--the VIX may be giving us a buy signal here (which would be bearish for the stock market). So far it's looking like a double bottom on its 200-dma, with bullish divergence at yesterday's low.

Volatility index, VIX, Daily chart

Good luck and I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 1105
- bearish below 1058

Key Levels for DOW:
- cautiously bullish above 10,595
- bearish below 10,040

Key Levels for COMPQ:
- cautiously bullish above 2260
- bearish below 2183

Key Levels for RUT:
- cautiously bullish above 650
- bearish below 617

Keene H. Little, CMT

New Option Plays

Long Play in Materials, Short Play On An Index

by Scott Hawes

Click here to email Scott Hawes


United States Steel - X - close 43.30 change +0.71 stop 39.75

Company Description:
United States Steel Corporation is an integrated steel producer of flat-rolled and tubular products with production operations in North America and Europe. The Company has an annual raw steel production capability of 31.7 million net tons (tons) (24.3 million tons in North America and 7.4 million tons in Europe). U. S. Steel is also engaged in other business activities, which are related to steelmaking operations, including the production of coke and iron ore pellets, and transportation services (railroad and barge operations), real estate operations, and engineering consulting services. It operates in three segments: Flat-rolled Products (Flat-rolled), U. S. Steel Europe (USSE) and Tubular Products (Tubular).

Target(s): 44.90, 46.20, 47.95
Key Support/Resistance Areas: 48.70, 46.25, 50-day SMA, 43.50, 40.50
Time Frame: 1 weeks

Why We Like It:
The steel sector has been beaten down and it appears to be gaining momentum and ready for move higher. X has broken out of its primary downtrend line from its highs on 4/6 and has now closed above its 20-day SMA 3 out of the past 4 days. The stock is creating an ascending triangle on its daily and intraday charts and I believe it should easily trade up to its 50-day SMA before the company's earnings on 7/27. I suggest readers initiate long positions on weakness in the stock. Our official trigger is $42.05 but readers may also consider $41.05. I'm just not convinced $41.05 will be triggered prior to the stock advancing. Our stop is relatively tight at $39.75 so if this is a false break out our losses will be limited. NOTE: I view this an aggressive and potentially quick trade. Please use proper position size to manage risk.

Suggested Position: Buy August $46.00 CALLS if X trades to $42.05, current ask $1.80, estimated ask at entry $1.30

Annotated Chart:

Entry on July xx
Earnings Date 7/27/10 (unconfirmed)
Average Daily Volume: 13.5 million
Listed on July 14, 2010


SPDR S&P 500 ETF - SPY - close 109.65 change -0.00 stop 112.60

Company Description:
SPDR S&P 500 ETF (the Trust), formerly SPDR Trust, Series 1, generally corresponds to the price and yield performance of the S&P 500 Index. The S&P 500 Index consists of 500 selected stocks, all of which are listed on the exchange, the NYSE or NASDAQ, and spans over 24 separate industry groups.

Target(s): 108.20, 107.25, 106.25
Key Support/Resistance Areas: 110.50, 108.80, 107.60, 106.00
Time Frame: 1 week

Why We Like It:
This is fairly simple. I'm looking for SPY to spike a tad bit higher to the 105.50 area (equivalent to 1105 in the S&P 500) and then retrace to fill its gap higher on 7/13 which is also just above its 20-day SMA. This is the primary target and is a good place to tighten stops to see if we can get more out of the trade. If we get filled I like this set-up a lot and I think the retracement could come quick. Our trigger to enter short positions is $110.35 and our stop will be above all recent closing highs at $112.60 and the 200-day SMA. If we get filled on this trade I will be thoroughly amazed if we get stopped out prior to hitting our target. But the market can do anything so it is possible, but not probable in my opinion. I think we have a 50/50 chance of getting filled so traders may consider entering at current levels with a tighter stop just above the 200-day SMA at $111.75.

Suggested Position: August $108.00 PUTS, current ask $2.64, estimated ask at entry $2.35

Annotated chart:

Entry on July xx
Earnings N/A (unconfirmed)
Average Daily Volume: 251 million
Listed on July 14, 2010

In Play Updates and Reviews

Relatively Flat Day Heading Into OPEX

by Scott Hawes

Click here to email Scott Hawes

Editor's Note: Good evening. I do not have any updates on open positions as everything was relatively flat heading into OPEX. I am expecting our revised targets to be hit on our short positions when the market gives back some its recent move. We may need to be patient with these positions until after OPEX on Friday, but anything can happen and we could get a sharp sell-off depending on earnings reports, etc. Please email me with any questions.

Current Portfolio: